Behavioral Finance Economics 437

Current Reading (Jan 21-26) Malkiel (online) Shiller (online) Shleifer (book, Ch 1) Fama (online)

Reading (starting Jan 28) “Noise Trading” – Limits to Arbitrage Black on Toolkit Shliefer on Toolkit Burton & Shah, pp 1-51

The Efficient Market Hypothesis (EMH) Price captures all relevant information Modern version based upon “No Arbitrage” assumption Why do we care? Implications Only new information effects prices Publicly known information has no value Investors should “index” Allocation efficiency

The Efficient Market Hypothesis (according to Fama 1970) Three forms: Weak Semi-strong Strong Differ by what information is used Weak – past stock prices and returns Semi-strong – publicly known information Strong – all information including private

Fama 1970 Article Random Walk Special Case is the “Fair Game” model f(rj, t+1|Φt) = f(rj, t+1) Where the density function ft is the same for all t Special Case is the “Fair Game” model E(pj, t+1|Φt) = [1 + E(rj, t+1|Φt)]pj,t Sub-martingale E(pj, t+1|Φt) ≥ pj,t or E(rj, t+1|Φt) ≥ 0

Fama’s Conclusions Weak form strongly supported by data Semi-strong seems to be supported but Some evidence of return correlation Strong form contradicted by market maker study

But “traders” saw things otherwise January tells the tale Blue Monday; Happy Friday Good market precede holidays Trading Rules Technical analysis (charting stock prices) Graham and Dodd “Security Analysis” 1934 Price momentum (related to charting) Booms and busts

The Milton Friedman argument for market efficiency in the presence of “noise traders” If noise traders are truly “random,” then their effects will “cancel out.” (Kind of a law of large numbers result) Noise traders are “systematic,” then arbitrage traders will “trade against them” and take all of their money Thus prices will be efficient in either case

The Law of One Price Can the same product trade at two different prices without some tendency for the two prices to converge to one another? Law of One Price says “no” But…….. Oct 19 1987 (22% drop with no information change) Royal Dutch Shell Closed End Funds Palm Pilot Stub Meanwhile: Kahneman and Tversky DeBondt and Thaler Winner’s Curse

The End